A Real Solution to the Social Security Crisis

Testimony of José Piñera
President of the International Center for Pension Reform
vd Co-Chairman of the Cato Project on Social Security Privatization

U.S. House Committee on Ways and Means

February 11, 1999

My name is José Piñera and I am a Chilean citizen. I learned to love your country during the four years that I spent at Harvard University, earning a Master in Arts and a Ph.D. in economics. Today, I am president of the International Center for Pension Reform and co-chairman of the Cato Institute’s Project on Social Security Privatization. As Minister of Labor and Social Security from 1978 to 1980, I was responsible for the creation of Chile’s private social security system.

I want to thank Chairman Archer for his invitation to me to testify in the U.S. House of Representatives. In keeping with the truth in testimony requirements, let me first note that neither the Cato Institute nor the International Center for Pension Reform receives any government money of any kind.

I believe there is no economic issue facing the world today that is more important than converting unfunded pay-as-you-go social security systems into fully funded systems of individual retirement accounts. For that reason, there has been great international interest in the pioneering Chilean social security model. This is a global crisis, affecting all countries, large and small, wealthy and poor, including the United States.

I am here to share with you an idea, a powerful idea that can improve the lives of all Americans. That idea was implemented in Chile 19 years ago when we approved the social security reform.

The Chilean USA System

On Nov. 4, 1980, Chile approved a law to fully replace a government-run retirement system with a fully funded privately administered system of Universal Savings Accounts (USAs).

The new system began to operate on May 1, 1981 (Labor Day in Chile). After 18 years of operation, the results speak for themselves. The main goals of the reform have been achieved: much better retirement benefits for all workers and control over their retirement savings. But there have been other important consequences. By improving the functioning of both the capital and the labor markets, the USA system has been one of the key initiatives that, in conjunction with other free-market reforms, have pushed the growth rate of the economy upwards from the historical 3 percent a year to 7.0 percent on average during the last 13 years.

In a recent work, UCLA Professor Sebastian Edwards has stated that, “The Chilean pension reform has had important effects on the overall functioning of the economy. Perhaps one of the most important of these is that it has contributed to the phenomenal increase in the country’s saving rate, from less than 10 percent in 1986 to almost 29 percent in 1996.” He goes on to say that, “The pension reform has also had an important effect on the functioning of the labor market. First, by reducing the total rate of payroll taxes, it has reduced the cost of labor and, thus, has encouraged job creation. Second, by relying on a capitalization system, it has greatly reduced--if not eliminated-- the labor tax component of the retirement system.”

Under Chile's USA system, what determines a worker's retirement benefits is the amount of money he accumulates during his working years. Neither the worker nor the employer pays a social security tax to the state. Nor does the worker collect government-funded retirement benefits. Instead, during his working life, he automatically has 10 percent of his wages deposited by his employer each month in his own, individual USA. A worker may contribute an additional 10 percent of his wages each month, which is also deductible from taxable income, as a form of voluntary savings.

A worker chooses one of the private Pension Fund Administra- tion companies (Administradoras de Fondos de Pensiones, or AFPs) to manage his USA. These companies can engage in no other activities and are subject to government regulation intended to guarantee a diversified and low-risk portfolio and to prevent theft or fraud. A separate government entity, a highly technical "AFP Superintendency" (Superintendencia de AFPs, or SAFP), provides oversight. Of course, there is free entry to the AFP industry.

Each AFP operates the equivalent of a mutual fund that invests in stocks and bonds. Investment decisions are made by the AFP. Government regulation sets only maximum percentage limits both for specific types of instruments and for the overall mix of the portfolio; and the spirit of the reform is that those regulations should be reduced constantly with the passage of time and as the AFP companies gain experience. There is no obligation whatsoever to invest in government or any other type of bonds. Legally, the AFP company and the mutual fund that it administers are two separate entities. Thus, should an AFP go under, the assets of the mutual fund--that is, the workers' investments--are not affected.

Workers are free to change from one AFP company to another. For this reason there is competition among the companies to provide a higher return on investment, better customer service, or a lower commission. Each worker is given a USA passbook and every four months receives a regular statement informing him how much money has been accumulated in his retirement account and how well his investment fund has performed. The account bears the worker's name, is his property, and will be used to pay his old age retirement benefits (with a provision for survivors' benefits).

As should be expected, individual preferences about old age differ as much as any other preferences. The old, pay-as-you-go system does not permit the satisfaction of such preferences, except through collective pressure to have, for example, an early retirement age for powerful political constituencies. It is a one-size-fits-all scheme that exacts a price in human happiness.

The USA system, on the other hand, allows for individual preferences to be translated into individual decisions that will produce the desired outcome. In the branch offices of many AFPs there are user-friendly computer terminals that permit the worker to calculate the expected value of his future retirement benefits, based on the money in his account, and the year in which he wishes to retire. Alternatively, the worker can specify the retirement benefits he hopes to receive and ask the computer how much he must deposit each month if he wants to retire at a given age. Once he gets the answer, he simply asks his employer to withdraw that new percentage from his salary. Of course, he can adjust that figure as time goes on, depending on the actual yield of his retirement fund or the changes in the life expectancy of his age group. The bottom line is that a worker can determine his desired benefits and retirement age in the same way one can order a tailor-made suit.

As noted above, worker contributions are deductible for income tax purposes. The return on the USA is also tax-free. Upon retirement, when funds are withdrawn, taxes are paid according to the income tax bracket at that moment.

The Chilean USA system includes both private and public sector employees. The only ones excluded are members of the police and armed forces, whose social security systems, as in other countries, are built into their pay and working conditions system. (In my opinion--but not theirs yet--they would also be better off with an USA). Self-employed workers may enter the system, if they wish, thus creating an incentive for informal workers to join the formal economy.

A worker who has contributed for at least 20 years but whose retirement fund, upon reaching retirement age, is below the legally defined minimum receives benefits from the state once his USA has been depleted. What should be stressed here is that no one is defined as "poor" a priori. Only a posteriori, after his working life has ended and his USA has been depleted, does a poor retiree receive a government subsidy. (Those without 20 years of contributions can apply for welfare-type benefits at a lower level).

The USA system also includes insurance against premature death and disability. Each AFP provides this service to its clients by taking out group life and disability coverage from private life insurance companies. This coverage is paid for by an additional worker contribution of around 2.6 percent of salary, which includes the commission to the AFP.

The mandatory minimum savings level of 10 percent was calculated on the assumption of a 4 percent average net yield during the whole working life, so that the typical worker would have sufficient money in his USA to fund benefits equal to 70 percent of his final salary.

Upon retiring, a worker may choose from two general payout options. In one case, a retiree may use the capital in his USA to purchase an annuity from any private life insurance company. The annuity guarantees a constant monthly income for life, indexed to inflation (there are indexed bonds available in the Chilean capital market so that companies can invest accordingly), plus survivors' benefits for the worker's dependents. Alternatively, a retiree may leave his funds in the USA and make programmed withdrawals, subject to limits based on the life expectancy of the retiree and his dependents. In the latter case, if he dies, the remaining funds in his account form a part of his estate. In both cases, he can withdraw as a lump sum the capital in excess of that needed to obtain an annuity or programmed withdrawal equal to 70 percent of his last wages.

The USA system solves the typical problem of pay-as-you-go systems with respect to labor demographics: in an aging population the number of workers per retiree decreases. Under the USA system, the working population does not pay for the retired population. Thus, in contrast with the pay-as-you-go system, the potential for inter-generational conflict and eventual bankruptcy is avoided. The problem that many countries face--unfunded social security liabilities--does not exist under the USA system.

In contrast to company-based private retirement systems that generally impose costs on workers who leave before a given number of years and that sometimes result in bankruptcy of the workers' retirement funds--thus depriving workers of both their jobs and their retirement rights--the USA system is completely independent of the company employing the worker. Since the USA is tied to the worker, not the company, the account is fully portable. The problem of "job lock" is entirely avoided. By not impinging on labor mobility, both inside a country and internationally, the USA system helps create labor market flexibility and neither subsidizes nor penalizes immigrants.

An USA system is also consistent with a truly flexible labor market. In fact, people are increasingly deciding to work only a few hours a day or to interrupt their working lives--especially women and young people. In pay-as-you-go systems, those flexible working styles generally create the problem of filling the gaps in contributions. Not so in an USA scheme where stop-and-go contributions are no problem whatsoever.

The Transition

Countries that already have a pay-as-you-go system have to manage the transition to an USA system. Of course, the transition has to take into account the particular characteristics of each country, especially constraints posed by the budget situation.

In Chile we set three basic rules for the transition:

1. The government guaranteed those already receiving retirement benefits that they would be unaffected by the reform. It would be unfair to the elderly to change their benefits or expectations at this point in their lives.



2. Every worker already contributing to the pay-as-you-go system was given the choice of staying in that system or moving to the new USA system. Those who left the old system were given a "recognition bond" that was deposited in their new USAs. (It was a zero coupon bond, indexed and with 4 percent real interest rate). The government pays the bond only when the worker reaches the legal retirement age. The bonds are traded in secondary markets, so as to allow them to be used for early retirement. This bond reflected the rights the worker had already acquired in the pay-as-you-go system. Thus, a worker who had made social security contributions for years did not have to start at zero when he entered the new system.



3. All new entrants to the labor force were required to enter the USA system. The door was closed to the pay-as-you-go system because it was unsustainable. This requirement assured the complete end of the old system once the last worker who remained in it reaches retirement age (from then on, and during a limited period of time, the government has only to pay retirement benefits to retirees of the old system).

After several months of national debate on the proposed reforms, and a communication and education effort to explain the reform to the people, the social security reform law was approved on November 4, 1980.

Together with the creation of the new system, all gross wages were redefined to include most of the employer's contribution to the old system. (The rest of the employer's contribution was turned into a transitory tax on the use of labor to help the financing of the transition; once that tax was completely phased out, as established in the social security reform law, the cost to the employer of hiring workers decreased). The worker's contribution was deducted from the increased gross wage. Because the total contribution was lower in the new system than in the old, net salaries for those who moved to the new system increased by around 5 percent.

In that way, we ended the illusion that both the employer and the worker contribute to social security, a device that allows political manipulation of those rates. From an economic stand- point, all the contributions are ultimately paid from the worker's marginal productivity, because employers take into account all labor costs--whether termed salary or social security contribu- tions--in making their hiring and pay decisions. By renaming the employer's contribution, the system makes it evident that workers make all contributions. In this scenario, of course, the final wage level is determined by the interplay of market forces.

The financing of the transition is a complex technical issue and each country must address this problem according to its own circumstances. The implicit pay-as-you-go debt of the Chilean system in 1980 has been estimated by the World Bank at around 80 percent of GDP. (The value of that debt had been reduced by a reform of the old system in 1978, especially by the rational- ization of indexing, the elimination of special regimes, and the raising of the retirement age.) A World Bank study stated that "Chile shows that a country with a reasonably competitive banking system, a well-functioning debt market, and a fair degree of macroeconomic stability can finance large transition deficits without large interest rate repercussions."

Chile used five methods to finance the transition to an USA system:

1. Since the contribution needed in a capitalization system to finance adequate social security levels is generally lower than the current payroll taxes, a fraction of the difference between them was used as a temporary transition payroll tax without reducing net wages or increasing the cost of labor to the employer (the gradual elimination of that tax was considered in the original law and, in fact, that happened, so that today it does not exist).



2. Using debt, the transition cost was shared by future generations. In Chile roughly 40 percent of the cost has been financed issuing government bonds at market rates of interest. These bonds have been bought mainly by the AFPs as part of their investment portfolios and that "bridge debt" should be completely redeemed when the retirees of the old system are no longer with us.



3. The need to finance the transition was a powerful incentive to reduce wasteful government spending. For years, the budget director has been able to use this argument to kill unjustified new spending or to reduce wasteful government programs, thereby making a crucial contribution to the increase in the national savings rate.



4. The increased economic growth that the USA system promoted substantially increased tax revenues. Only 15 years after the social security reform, Chile started running fiscal budget surpluses of around 2 percent of GNP.



5. Privatization of state-owned companies in Chile were another way to contribute, although marginally, to finance the transition. Of course, this had several additional benefits such as increasing efficiency, spreading ownership, and depoliticizing the economy.

The Results

The USAs have already accumulated an investment fund of $31 billion, an unusually large pool of internally generated capital for a developing country of 15 million people and a GDP of $70 billion.

This long-term investment capital has not only helped fund economic growth but has spurred the development of efficient financial markets and institutions. The decision to create the USA system first, and then privatize the large state-owned companies second, resulted in a "virtuous sequence." It gave workers the possibility of benefiting handsomely from the enormous increase in productivity of the privatized companies by allowing workers, through higher stock prices that increased the yield of their USAs, to capture a large share of the wealth created by the privatization process.

One of the key results of the new system has been to increase the productivity of capital and thus the rate of economic growth in the Chilean economy. The USA system has made the capital market more efficient and influenced its growth over the last 18 years. The vast resources administered by the AFPs have encouraged the creation of new kinds of financial instruments while enhancing others already in existence, but not fully developed. Another of Chile's social security reform contributions to the sound operation and transparency of the capital market has been the creation of a domestic risk-rating industry and the improvement of corporate governance. (The AFPs appoint outside directors in the companies in which they own shares, thus shattering complacency at board meetings.)

Since the system began to operate on May 1, 1981, the average real return on investment has been 11 percent per year, almost three times higher than the estimated yield of 4 percent. Of course, the annual yield has shown the oscillations that are intrinsic to the free market--ranging from minus 2.5 percent to almost 30 percent in real terms--but the important yield is the average one over the long term (see Table 1).

Real annual rate of return of Chile's private social security system

Source: Official Government Statistics (SAFP).

Retirement benefits under the new system have been significantly higher than under the old, state-administered system, which required a total payroll tax of around 25 percent. According to a recent study, the average AFP retiree is receiving benefits equal to 78 percent of his mean annual income over the previous 10 years of his working life. As mentioned, upon retirement workers may withdraw in a lump sum their "excess savings" (above the 70 percent of salary threshold). If that money were included in calculating the value of the benefits, the total value would come close to 84 percent of working income. Recipients of disability benefits also receive, on average, 70 percent of their working income.

The new social security system, therefore, has made a significant contribution to the reduction of poverty by increasing the size and certainty of old age, survivors, and disability benefits, and by the indirect but very powerful effect of promoting economic growth and employment.

When the USA was inaugurated in Chile in 1981, workers were given the choice of entering the new system or remaining in the old one. One fourth of the eligible workforce chose the new system by joining in the first month of operation alone. Today, more than 95 percent of Chilean workers are in the new system.

Social security is no longer a source of political conflict. A person's retirement income will depend on his own work and on the success of the economy, not on the government or on the pressures brought by special interest groups.

For Chileans, USAs now represent real and visible property rights--they are the primary sources of security for retirement. After 18 years of operation of the new system, the typical Chilean worker's main asset is not his used car or even his small house (probably still mortgaged), but the capital in his USA.

Finally, the private social security system has had a very important political and cultural consequence. Indeed, the new social security system gives Chileans a personal stake in the economy. A typical Chilean worker is not indifferent to the behavior of the stock market or interest rates. Intuitively he knows that his old age security depends on the wellbeing of the companies that represent the backbone of the economy.

The Global Social Security Crisis

The real specter haunting the world these days is the specter of bankrupt state-run social security systems. The pay-as-you-go social security system created by Chancellor Otto Von Bismarck has a fundamental flaw, one rooted in a false conception of how human beings behave: it destroys, at the individual level, the essential link between effort and reward--in other words, between personal responsibilities and personal rights. Whenever that happens on a massive scale and for a long period of time, the result is disaster.

Two exogenous factors aggravate the results of that flaw: (1) the global demographic trend toward decreasing fertility rates; and, (2) medical advances that are lengthening life. As a result, fewer workers are supporting more and more retirees. Since the raising of both the retirement age and payroll taxes has an upper limit, sooner or later the system has to reduce the promised benefits, a telltale sign of a bankrupt system.

Whether this reduction of benefits is done through inflation, as in most developing countries, or through legislation, the final result for the retired worker is the same: anguish in old age created, paradoxically, by the inherent insecurity of the "social security" system.

The success of the USA system in Chile has led seven other Latin American countries to follow suit. In recent years, Peru (1993), Argentina (1994), Colombia (1994), Uruguay (1995), Mexico (1997), Bolivia (1997), and El Salvador (1998) undertook similar reforms. It is possible that before entering the new millennium, several other countries in the Americas will have implemented USA systems instead of unfunded government-run social security ones. This would mean a massive redistribution of power from the state to individuals, thus enhancing personal freedom, promoting faster economic growth, and alleviating poverty, especially in old age.

Mr. Chairman, let me conclude with a warning about the damaging moral effects of unfunded social security and other entitlement programs issued at the dawn of the New Deal: The lessons of history, confirmed by evidence immediately before me, show conclusively that continued dependence on relief induces a spiritual and moral disintegration fundamentally destructive to the national fiber. To dole out relief in this way is to administer a narcotic, a subtle destroyer of the human spirit. It is inimical to the dictates of sound policy. It is a violation of the traditions of America.

That warning was issued by President Franklin Delano Roosevelt in his 1935 State of the Union address.

I believe that the road is clear in the United States to replace a Bismarckian program with a system that is so inherently consistent with American values.

Thank you very much.

Notes

This section follows Josç Piñera, "Empowering Workers: The Privatization of Social Security in Chile." Cato's Letter No. 10, Cato Institute (1996).

Sebastian Edwards, “The Chilean Pension Reform: A Pioneering Program.” In M. Feldstein, ed., Privatizing Social Security, Chicago, Ill.: University of Chicago Press (1998).

World Bank, Averting the Old Age Crisis (1994).

Franklin D. Roosevelt, The Public Papers and Addresses of Franklin D. Roosevelt, Vol. 4, The Court Disapproves: 1935, Random House (1938).